The past two weeks have been odd ones for me. I will be a lawyer by trade, but I have acquired some secondary expertise in the business world. As is my habit, I shoot off my mouth on various occasions in a way that tends to strain credulity. Thus, a few years ago, I predicted the eventual clash between Wall Street and Main Street at an event in New York City – a prediction born out of more than five years experience in turbulent waters of the cryptocurrency world.
I went out on such a limb in my prediction that I predicted the time frame that it would happen, the forum that Main Street would use to coordinate its activities, the reactions of the exchanges and institutional investors, and the stocks. I was correct on every aspect of my prediction except for the stocks – where I batted 1 for 7 (the only stock that I picked properly was Nokia). Everyone who heard my prediction thought that I was nuts so I picked up my soapbox and went home to watch.
Thus, it came as no surprise that the deluge of questions from old acquaintances hit me when my prediction came to pass during the GameStop short squeeze. To some, I represented a sense of bewilderment. To others, I represented a glimmer of hope and stability in a perilously unstable financial market.
I get it. I really do. What happened over the past 2 weeks shook the perception of market stability that all financial markets require to survive. People lost a lot of money, and they are scared that they will lose a lot more. They’re turning to the government and to any knowledgeable person both for an indication that this will not happen again and regulation to make sure that it will not happen again.
I don’t have novel or hopeful answers for you. I do have “grow up” answers though. As usual with “grow up” answers, “why” is more important than “what.” Let’s talk “why”.
- Why did the GameStop short squeeze happen?
As a general proposition, Main Street investors – the average joes with an appetite for speculation – will always possess more potential investment capital than Wall Street investors. Wall Street, however, will always possess more kinetic investment capital – actively invested capital – than Main Street.
Over the past ten years, federal regulatory authorities have taken steps to broaden the investment opportunities available to “Main Street” investors. Developments such as Regulation A offerings have opened investment opportunities that only Wall Street firms had access to previously. Thus, more Main Street investors have entered markets traditionally reserved for Wall Street investors, and, in some small way, have narrowed the gap in kinetic capital differential.
What Wall Street and the regulatory authorities have neglected to account for is the type of Main Street investor who dominates the speculative market. Main Street investors are not “sophisticated.” In other words, they usually do not make their investment decisions based on careful data analysis of financial statements and other traditional indicia of financial movements. Instead, Main Street investors are sentiment-driven. They have a tendency to jump on the proverbial band wagon in a lot of instances.
Sentiment-driven investment is nothing new. In fact, Wall Street and corporations have created their own version called impact investing – a form of investing putatively designed to support socially responsible causes while quietly turning a profit both financially and image-wise.
Trends rule the sentiment-driven investment market. They can range from causes to a simple group belief that an investment will yield a return. I saw more cryptocurrency trends and sentiment stampedes over alt-coins than I count. I made money off of them, but I also received more than a few lessons in their irrationality – no, thanks, green crypto, you’re before your time.
By and large, Wall Street tends to ignore Main Street’s sentiment-driven investments in the sense that it does not follow the trends. Instead, institutional investors represent the bettors on the other side of the table who bet on the sentiment-driven investment crashing and burning.
You can’t blame Wall Street. The attitude is successful in the vast majority of cases, and leveraging the resources to monitor Main Street trends is horribly inefficient although artificial intelligence might provide the solution some day.
A day, however, will inevitably come where Wall Street’s disregard for Main Street’s trends results in a sufficiently large swing in the markets as to cause Wall Street to lose major money. That day invariably is bad for Wall Street and unsettling to economic stability because the same sentiment-based attitudes that influence Main Street speculation influence Main Street living. In other words, our society has acquired a conscious dependency that our economic prosperity is linked to certain branded institutions that can bring down the entire economy if they suffer a bad day.
Financially, Wall Street loses because it could not foresee the influence that Main Street would have on the market.
2. What happened in the GameStop Short Squeeze?
GameStop is a video games retailer that depends on brick-and-mortar stores to move its products. Over the past decade, that business model has gradually been supplanted by the online distribution of video games – the ultimate convenience experience for the hard-core gamer. The ongoing COVID-19 pandemic drove a deeper nail into the business model’s coffin because the hard-core couch potatoes were too afraid to don their Rambo gear and charge into a store to buy video games.
In April 2020, Gamestop’s stock price dropped to $3.25 after it announced $470 million in losses and that it would close 300 locations permanently. To put that in perspective, it reported $340 million in profits about eight years ago.
Its financial statements show a company that has been mismanaged and in decline since 2015, but fortunes appeared to change in August and November 2020. Ryan Cohen – the founder of pet food giant Chewy – bought 13% of GameStop’s stock in August. In November, he took the company board to task for its decision making. The publicity forced change.
GameStop appointed him and two of his associates to its board, and Main Street investors struck an optimistic view of the development, viewing him as a corporate savior who would magically restore GameStop to its former glory. GameStop’s stock price rose from $20.42 to a high of $38.65 before settling at approximately $31.40.
Wall Street saw an opportunity. It shorted or bet that GameStop’s stock price would fall. So confident was Wall Street that GameStop would crash and burn, it shorted more GameStop stock than was publicly available.
Main Street then saw an opportunity. A user on the Reddit form published a treatise detailing how Main Street could save GameStop and screw Wall Street at the same time. Main Street’s reaction was unparalleled in traditional investment, but quite normal by cryptocurrency standards. Once enough investors had an understanding of what to do, they built a bandwagon and jump on.
This was not about investing although the initial investors understood that they would be able to make at least modest gains by exploiting Wall Street’s overreaction. This was war between Wall Street and Main Street, the sophisticated and the couch potatoes, the upstanding citizens and the rebels.
GameStop’s stock price spiked to $347.51 two week ago. Wall Street lost a ton of money, but the stock has since crashed back to $50.31. Reality has set in. GameStop is a bad investment over the long haul.
3. What about the reaction?
To be honest, the reactions from Wall Street and regulatory authorities are the most interesting aspect of this to me. Wall Street predictably seethed. It had lost big time to a bunch of idiots. Trading platforms stopped trading on GameStop and other stocks involved in the squeeze. They pulled cryptocurrency from their platforms to keep Main Street from turning additional profits.
The regulatory authorities promised investigations. Investigations into what? There is certainly plenty of fodder for the regulatory agencies in exploring Wall Street’s reaction to losing. Wall Street, however, carries a tremendous amount of lobbying power and has already began to put pressure on the regulatory authorities to investigate the Reddit group that started this trend.
I could barely contain my gleeful anticipation when I heard. You see, I think that any investigation of the Reddit group and its participants would constitute a categorical First Amendment violation, and I would be thrilled if the targets of such an investigation gave me a call to take on the federal government for them. Why?
A federal investigation into the Reddit group will likely focus on the unauthorized marketing of securities and collusion within the market. In other words, it will target both free speech and free association.
First Amendment law hasn’t explicitly caught up to securities regulations yet. Many securities laws that restrict speech are still based on the commercial speech exception to the First Amendment. The evolution of the exception is a curious one, and it might have evolved in non-existence.
Prior to 1976, the First Amendment did not protect commercial speech as the Supreme Court recognized in Valentine v. Chrestensen in 1942. The Supreme Court first held that the First Amendment protected commercial speech in the 1976 case, Virginia State Pharmacy Board v. Virginia Citizens Consumer Council, but it held that it did not enjoy the same protection as non-commercial speech. The Supreme Court articulated its first full-fledged test in Central Hudson Gas & Electric Corp. v. Public Service Commission in 1980.
Its Central Hudson decision stood virtually unchallenged – despite a few dissenting justices – until 2011. In Sorrell v. IMS Health Inc., the Supreme Court characterized a traditional economic regulation as a content and speaker-based restriction on speech, thus entitling the speakers to the most rigorous form of First Amendment protection.
More development soon came. In the 2015 case of Reed v. Town of Gilbert, the Supreme Court held that all content-based restrictions on speech automatically trigger “strict scrutiny” – the most favorable First Amendment test that a speaker can receive in federal court. Its 2018 decision in NIFLA v. Becerra adopted a similar standard for speaker-based restrictions, stamping the final nail in the commercial speech exception’s coffin in my opinion.
The developments in Sorrell, Reed, and NIFLA prohibit the government from regulating speech based on its content and who utters it. Period. Full stop. Exclamation point.
The only reason why the federal government would investigate the Redditors would be for what they said and who said it. Nothing that they said, however, strips them of their First Amendment protections. They believed in a cause – saving a cherished American institution and pushing back against the reprehensible actions of Wall Street. They spoke in support of that cause. They associated to carry out their beliefs. They have done nothing worse than an impact investor does, and they did it with more heartfelt sincerity than the hypocritical, self-serving motives underlying impact investing.
Who cares who they are or what they said? They enjoy the protection of the First Amendment, and, if Wall Street and the federal government can investigate and punish them, the federal government and Wall Street can investigate and punish anyone for their speech just because they don’t like who said it and what was said.
If I were a Redditor involved in this (and I may or may not be), I would refuse to cooperate in any federal investigation, and I would even seek proactive judicial relief on the investigation if necessary. If the federal government wants a fight, let them butt their head against the First Amendment.
4. Do you have any solutions?
Yes. Uncle Sam, investigate Wall Street’s activities on pulling stocks and cryptocurrencies as investment options. Wall Street, grow up and leverage artificial intelligence to stay abreast of developments like this again so you don’t get caught with your pants down again. America, stop being hysterical.
Markets are not eternal sentences of doom. They operate around natural equilibrium points. When the market operates around a natural equilibrium point, wins and losses are marginal and acceptable. When the market strays away from a natural equilibrium point, wins and losses reach levels that are eye-opening and “unacceptable” – whatever that means.
A market only strays away from a natural equilibrium point temporarily due to a knowledge gap. This is not a case where bad behavior created a knowledge gap. This is a situation where choices and investing strategies resulted in a knowledge gap. No one withheld information from anyone. Some people chose to avail themselves of that information. Others ignored it. They have each reaped the consequences.
Markets naturally return to a state of equilibrium. The road back is not always smooth. The federal government shouldn’t add any more bumps to that road.
The economy will not collapse. Let’s focus on protecting our First Amendment.